The theory and practice of corporate finance: Evidence from the field

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The theory and practice of corporate
financeEvidence from the field
Complementary Research Methodologies The
Interplay of Theoretical, Empirical and
Field-Based Research in Finance Harvard Business
School - Journal of Financial Economics, July
7-9, 1999.
John R. Graham Duke University Campbell R.
Harvey Duke University National Bureau of
Economic Research
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Overview

• Survey CFOs to find out
• How they choose capital structure
• How they estimate/use cost of capital
• Which capital budgeting tech. they use
• Ask 15 questions
• many subparts (over 100 total questions)
• firm characteristics
• CEO age, tenure, education, share ownership
• firm P/E, debt rating and ratio, revenues, etc.
• Descriptive vs. draw inference on theory

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Who and how did we survey?

• Financial Executives Institute (FEI)
• 9,000 total members 4,400 list a CFO/Treasurer
• firms represent various sizes, industries
• fax survey 1 week to respond
• refax to everyone 3 days to respond
• surveys were received over three week period
• Fortune 500
• mail survey one week to fax back
• phone call, fax second copy of survey if needed
• remail to everyone

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Survey design

• Read, reviewed many articles
• review available on www.duke.edu/charvey
• Prepared initial, rough survey
• Circulated to 15-20 academics, FEI
• changed/added questions
• altered survey design
• Ran beta tests at FEI and Fuqua
• goal 15 minutes to complete
• Modified survey one last time
• final survey instrument in appendix of paper

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How good is survey evidence?

• Are executives optimizing?
• How interpret their responses?
• Darwinian economics
• Can they express what they are doing?
• Can we ask questions properly?
• Find out what companies actually do.

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Response bias?

• 9 response rate
• FEI (8 out of 4,400)
• Fortune 500 (14 out of 500)
• Similar response rate as recent surveys
• What about the other 91?
• check early vs. late
• compare firm char respondents vs. universe
• Goodness-of-fit
• Bootstrapping universe and Compustat
• Also different ordering of questions.

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Summary information

• Percent that seriously considered issuing
• common stock 64
• convertible debt 20
• foreign debt 31
• Percent of firms that are
• public 63
• regulated utility 7
• pay dividends 53
• calculate cost of equity 64

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Figure 1
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Figure 1
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Capital budgeting

• What techniques does your firm use to evaluate
  projects?
• Gitman and Forrester (1977) find only 9.8 of
  firms use NPV
• We find 74.9 of respondents always or almost
  always use NPV

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Capital budgeting

• What techniques does your firm use to evaluate
  projects?
• Size makes a difference!
• Large firms score NPV 3.42/4.00
• Small firms score NPV 2.83/4.00
• Small firms use payback as much as NPV
• CEO education
• CEOs with MBAs more likely to use NPV

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Cost of capital technique

• How does your firm estimate cost of equity
  capital?
• Gitman and Mercurio (1982) find 29.9 of
  participants use the CAPM
• We find 73.5 use some form of CAPM

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Cost of capital technique

• How does your firm estimate cost of equity
  capital?
• Size is important
• Large firms score CAPM 3.27/4.00
• Small firms score CAPM 2.49/4.00
• Education
• CEOs with MBAs more likely to use CAPM

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Cost of capital technique

• How does your firm estimate cost of equity
  capital?
• Dividend discount models popularity is waning
• Gitman and Mercurio (1982) find 31.2 use a DDM
  to establish cost of capital
• Our participants score the DDM 0.91/4.00

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Risk factors

• What are the most important risk factors and do
  you use them in cash flows, discount rate or
  both?
• Large firms
• Market, FX, business-cycle, inflation and
  interest rates
• Ferson and Harvey (1993) Market, FX, inflation,
  interest rates
• Small firms
• More impacted by interest rate risk than FX

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Risk factors

• What are the most important risk factors and do
  you use them in cash flows, discount rate or
  both?
• Momentum not important
• Used by only 11.1 of respondents
• Book to market not important
• Used by 13.1 of respondents

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Project evaluation

• What discount rate do you use for an overseas
  project?
• More than half would always or almost always
  use the single company-wide discount rate
• Other half use a discount rate that reflects the
  particular project risks

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Project evaluation

• What discount rate do you use for an overseas
  project?
• Implies that many (half) view investment overseas
  to have identical risk to domestic investment -
  or that international risks have been ignored.
• Size makes a difference
• Risk matched discount rate scores 2.34/4.00
  (large) versus 1.86/4.00 (small)
• Fortune 500 risk-matched discount rate obtains a
  2.61/4.00 score.

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Capital structure

• What is your
• credit rating
• long-term debt ratio
• Do you have a target debt ratio?
• What factors affect your choice of
• amount of debt
• target/deviation from target
• short-term vs. long-term debt
• issuing convertible debt
• issuing foreign debt
• issuing equity

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Target debt ratio or range?
Figure 1G

• Somewhat tight or strict (overall 44)
• large (55) small (36)
• investment grade (65) speculative (41)
• regulated (67) unregulated (43)

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What factors affect debt policy?

• Important () Unimportant ()
• 59.4 fin. flexibility 0.0 bargain with
  employees
• 57.1 credit rating 1.1 accumulate past profits
• 48.1 CF volatility 1.7 mgmt work hard
• 46.8 insufficient CF 2.3 threat to competitors
• 46.4 low interest rates 4.8 takeover deterrent
• 44.9 tax deduction 4.8 personal tax cost
• 9.8 impression of prospects
• that say option is important (3) or very
  important (4)

Tables 5/6
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Short-term vs. long-term debt?

• Important ()
• 63.3 maturity match private (67.4), small (66.4)
• 48.8 issue long-term to high debt (62.8)
• avoid refinancing in
• bad times
• Unimportant ()
• 4.0 asset substitution
• 9.0 time credit rating
• 9.5 underinvestment

Table 7
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Convertible debt

• Important ()
• 58.1 delayed equity
• 50.7 stock undervalued nonMBA CEO (55.6)
• 48.0 force conversion
• 43.8 investors unsure riskiness small (50.0)
• Unimportant ()
• 1.4 asset substitution
• 12.5 other firms in industry use

Table 10
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Foreign debt

• Important ()
• 85.8 natural hedge large (88.3), foreign
  exposure (88.3)
• 63.4 source close to use
• 52.3 low foreign interest rates
• 44.3 foreign tax treatment large (55.9), public
  (54.7)
• Unimportant ()
• 5.5 foreign regulations

Table 8
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What factors affect equity policy?

• Important () Less important ()
• 68.6 EPS dilution 5.0 personal tax advantage
• 66.9 stock valuation 14.1 stock is cheapest
• 62.6 recent stock price 15.6 other sources used
  up
• 53.3 emp. stock plans 21.5 impression of
  prospects
• 51.6 target D/E 23.0 other firms in industry
• 50.4 dilute shares of 30.4 recent profits
• certain shareholders

Table 9
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Capital structure overview

• Moderate support for trade-off theory
• corporate taxes (), personal taxes (-)
• bankruptcy costs (-), CF volatility ()
• Moderate support for pecking order
• financial flexibility important ()
• importance unrelated to asymmetric info (-)
• Less support for other theories
• underinvestment absolute and relative support
• Practical rules important
• credit rating, EPS dilution, fin. flexibility

Table 11
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Perspective

• Todays empirical research takes one of two
  approaches
• Large sample studies
• Clinical/case studies
• We offer a third alternative

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Perspective

• We analyze
• the behavior of managers like clinical studies
• on a grand scale like large sample studies
• Control variables tell us whether behavior is
  consistent with theory
• lack of support of a particular theory does not
  necessarily invalidate the theory

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Perspective

• Though theories are always difficult to test, our
  work provides fresh insights -- from an
  alternative methodological perspective
• There are many questions for the future
• Many issues could be explored with our current
  dataset
• Future survey planned on dividend policy

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Ongoing research

• Questions such as
• Correlation (financial flexibility in capital
  
• structure, real
  options)
• Relate managerial views to actions and
  fundamental characteristics of the firm